Investing during a long down market

Investing tip: What to do if down market lasts a decade

DeborahAdamson

First, the summer rally didn't appear. Then the Dow Jones Industrial Average buckled to below 10,000 this week. Portfolios continue to be bludgeoned to death -- or at least a coma.

But there are ways to make money during a down market, even if it turns out to be a protracted malaise.

"We have been buying puts and shorting stocks," said David Tice, manager of the Prudent Bear fund. "We see a vast number of overpriced stocks that we believe will decline in price."

While others are losing their shirts over technology, he's profiting from shorting tech, consumer, semiconductor and financial stocks.

The Prudent Bear has 65 percent of its holdings in short positions, 20 percent in longs, 5 percent in puts and 10 percent in cash. Shorts and puts are bets that profit from a security's decline in value.

Where is Tice long? "Defense contractors, gold and silver mining and out-of-favor biotechs," he said.

The Prudent Bear Fund
BEARX, +1.08%
is up 9 percent for the first eight months of the year, compared with a decline of 14 percent for the S&P 500, according to Lipper Analytical. In a year, the fund has risen 50 percent as the S&P 500 dropped 24 percent.

His fund does well when the market's ailing. A look at his fund's weekly chart over the last two years shows it going the opposite direction of the market.

Not surprisingly, the fund didn't do well during a roaring bull market. Indeed, the Prudent Bear was down almost 9 percent a year on average in the last five years. Since the fund opened in late December of 1995, it's down 41 percent.

Hedge funds

Hedge funds also are doing well in this environment, said Pete Gallo, editor of the Hedge World, a trade publication in New York.

For the first seven months of the year, they're up an estimated 2.1 percent overall vs. a decline of 8 percent for the S&P 500, he said. Funds tilted toward shorting -- many are short large cap tech companies in areas such as telecom -- are up 3.7 percent.

In down markets, hedge funds are better at preserving capital.

In the last 12 market downturns, the S&P 500 was down 62.72 percent collectively while the average U.S. stock fund was down 67 percent, according to the Hedge Fund Association. In contrast, the average hedge fund was down just 0.4 percent.

Hedge funds tend to attract the best money managers because of the compensation level, the trade association said.

It's not unusual for hedge funds to charge a management fee of 1 percent of assets and 20 percent of profits, Gallo said.

One of the most famous hedge fund managers in recent years is Jeff Vinik, who left Fidelity Magellan when a bet on bonds didn't pan out. But the subsequent hedge fund he ran was quite successful.

The three-year return of his fund was 76 percent in 1997, 45 percent in 1998 and 29 percent in 1999, according to Gallo. Vinik gave back to clients most of the fund's $4.2 billion in holdings last fall.

Unlike mutual funds, hedge funds are private. Managers have greater leeway on how to invest the money they receive and they don't have to be registered with the Securities and Exchange Commission. There are between 5,000 to 7,000 hedge funds, according to estimates by Gallo and the Hedge Fund Association.

Hedge funds can use several alternative investment strategies to protect a portfolio against market downturns -- selling short, arbitraging, betting on currencies, using leverage and derivatives, and others. These strategies usually are beyond the reach of mutual funds due to SEC regulations, the trade group said.

While the public is more familiar with hedge fund disasters -- such as Long-Term Capital Management -- hedge funds' risk levels actually range from conservative to very risky, Gallo said.

Hedge funds are beyond the reach of most individual investors. Only institutions and wealthy people can get into a hedge fund, Gallo said.

But a new trend has emerged in the past year or so that could allow comfortable, but not ultra-wealthy, investors participate, he added. These are hybrid funds that incorporate characteristics of mutual and hedge funds, Gallo said.

One, the Invesco Advantage Fund, has minimum investments as low as $1,000 for regular investors and $250 for IRA accounts.

The newly launched fund bills itself as "hedge-like" in that it can short stocks, use leverage and put up to 25 percent of its holdings in foreign stocks. It is an aggressive growth fund.

But such strategies for any fund can be quite risky. The focus on the money managers' skill may well be magnified.

If managers execute well, investors can potentially profit greatly. If not, there's the possibility of major losses as well especially if they make a big bet that's wrong. Caveat emptor: Buyer beware.

Investing tip:

The last 10 years have been among the best in history for stocks. The next 10 years could be the worst, Tice said. "This market could go a lot lower," the bear fund manager said. What makes him think so? A look at market and economic history and an analysis of individual companies. Bears can last for years, he said. For instance, a 15-year bull market was followed by a 15-year bear that ended in the early1980s. So what should investors do? "Stay in cash," he said.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.